What it is:
How it works (Example):
The Herfindahl Index formula is calculated by squaring the market share for each firm (up to 50 firms) and then summing the squares.
Here's an example:
Let's say there are four grocery stores in your town: Albert's, Bob's, Carl's and Donald's. Market share is broken down as follows:
HHI = 502 + 252 + 152 + 102 = 3,450
In a perfectly competitive market, HHI approaches zero. Let's say there are thousands of restaurants in your city, but the top 50 each have 0.1% of the market share. The HHI is 0.12 x 50 = 0.5.
In a monopoly, HHI approaches 10,000. If the one largest firm has 100% of the market share, HHI = 1002 = 10,000.
Why it Matters:
Most analysts do some sort of industry analysis to understand where a particular company's source of growth and competitive advantage comes from, and competition structure is one of the main components of industry analysis. For example, if a company exists in a highly competitive industry, it will be more difficult for it to maintain above-average profit margins in the future, even if it has above-average profit margins today.
Furthermore, the Justice Department uses the Herfindahl Index to decide whether a merger is good for competition in the marketplace. A market with an HHI under 1,000 is considered competitive. The Justice Department is likely to scrutinize a merger in an industry with a post-merger HHI of between 1,000 and 1,800, and it is almost certain to outright reject approval for mergers that result in a post-merger HHI exceeding 1,800.